Perhaps reform of the excessive cost and bureaucracy created by the Sarbanes-Oxley Act will be a bipartisan effort, just as the original act was a bipartisan overreaction to the scandals of its day.
Future House Speaker Nancy Pelosi is reported to favor changes to Sarbanes-Oxley, especially for smaller companies. Rep. Tom Feeney and Sen. Jim DeMint have already introduced reform bills, and Sen. Charles Schumer co-authored an op-ed arguing for re-examination of the act.
Meanwhile, SEC Chairman Christopher Cox has said his agency "will unveil significant changes" in regulation to diminish the cost of compliance. Last summer, in reaction to resounding criticism of the implementation of the act's Section 404 in particular, the SEC published a "Concept Release."
It would certainly be desirable for the SEC to address the problems that have made the implementation of Section 404, the external auditor certifications of internal controls, a synonym for wasteful expense, bureaucracy, and paperwork.
With costs that have outweighed the benefits, Sarbanes-Oxley implementation has been to the net detriment, not benefit, of investors.
Consistent with this conclusion, Alan Greenspan has suggested that, as summarized by the Boston Herald, the rules have "become a 'nightmare' and should be scrapped."
But the problem with the SEC's Concept Release in response to this criticism is that it focuses on "additional guidance." What is needed is not additional guidance, but different and better guidance. The required project is much more fundamental than the Concept Release seems to presuppose.
Here are the key items in need of fundamental change, either by the SEC or by Congress:
Smaller companies. Section 404 should be made voluntary for smaller companies (and certainly for small banks, which are already intensively and expensively regulated). Alternately stated, these companies should have the ability to "opt out" of Section 404, with corresponding disclosure to investors, including the reasons for the company's decision.
Former SEC Chairman Arthur Levitt and others maintain that Section 404 compliance should be mandatory for all public companies, because it will cause investors to pay more for their securities ("lower their cost of capital"). But in fact this is a perfect argument for a voluntary system. If it be true that investors will pay more for a company's stock and bonds because it implements Section 404, it will voluntarily do so.
But what if it is not true? What if investors conclude that Section 404 costs far more than it is worth and thereby reduces the value of their investment? Companies will respond accordingly.
The judgments and the point of view of investors should prevail, not the point of view of accountants trying to protect themselves from PCAOB criticism or from the fate of Arthur Andersen, while at the same time making exceptional profits from adding to the burden on companies.
A voluntary approach is superior, at a minimum for small companies.
A similar approach was reccomended by SEC's Advisory Committee on Smaller Public Companies. A voluntary approach is not only better suited to a market economy and a free society, but it is the way to let market discipline reduce the morass of expense and bureaucracy which Section 404 implementation has unintentionally created.
Materiality and frequency. An essential reform is to fix the audit review standard of "other than a remote likelihood," which has caused Section 404 implementation to be everywhere associated with nitpicking and trivial paperwork. This should be changed to reasonable material weakness criterion, specifically: "a material risk of loss, misstatement, or fraud."
Another simple and sensible way to reduce the heavy cost of Section 404 audits, in either a mandatory or voluntary system, would be to make them less frequent after the first year of compliance.
Every three years would be reasonable, for example.
Auditor advice. Another required reform of Sarbanes-Oxley implementation is the unambiguous statement that rendering advice on the application of accounting standards is not only permitted, but expected and required of external auditors as part of their professional responsibility.
An absurd unintended effect of implementation has been in many cases to make the audit engagement team unwilling or unable, without deadening internal accounting firm bureaucracy, to perform this essential professional function.
As part of this reform, the SEC should help make it clear to the press, the public, and Congress that accounting is not something objective, but that it is replete with more or less subjective judgments, choices among highly debatable accounting theories, and estimates of the unknowable future - all making professional consultation and advice essential.
As a prime example, nothing could make this problem more obvious than trying to cope with the byzantine, conceptually confused and confusing FASB standard 133 on accounting for derivatives.
Of course no financial professional has the naïve belief that accounting is something objective, and no one at the SEC should believe this, but this illusion is common among those not trained in finance.
Auditor conflict of interest. Reform of Section 404 implementation needs to address the fundamental conflict of interest for accounting firms which is involved.
As is well known, Sarbanes-Oxley implementation has been and continues to be a financial bonanza for these firms at the expense of corporate shareholders. The more detailed and burdensome they make the Section 404 routines, the more generous are the profits of the accounting firm partners.
The problem is compounded by the existence of only four principal firms, which in reality gives most companies very little choice; hence there is much less than optimal competition and the large firms enjoy pricing power.
It would greatly help matters for the SEC to implement the congressional intent of Sarbanes-Oxley as expressed by the Report of the Senate Banking Committee on Section 404: "The committee does not intend that the auditor's evaluation be the subject of a separate engagement or the basis for increased charges or fees."
In sum, reform of Sarbanes-Oxley implementation has a long way to go. To close with a prediction: If the SEC follows its Concept Release direction, it will end up only adding to the excess of rules, procedures, and bureaucracy. Fundamental reform will then require the Congress to act.
